Afghanistan’s largest commercial bank, Kabul Bank, went into turmoil after its top two directors stepped down in early September 2010 amid allegations of systemic corruption. Kabul Bank shortly thereafter froze the assets of the former chairman and former chief executive officer, as well as those of several other shareholders and major borrowers. USIP’s Raymond Gilpin provides context and offers his perspective on this crisis.
Afghanistan’s largest commercial bank, Kabul Bank, went into turmoil after its top two directors stepped down in early September 2010 amid allegations of systemic corruption. Kabul Bank shortly thereafter froze the assets of the former chairman and former chief executive officer, as well as those of several other shareholders and major borrowers.
Authorities have cited questionable lending practices involving Afghanistan’s political elite and risky investments in Dubai. The announcement triggered a run on the bank by depositors and raised serious doubts about the health and sustainability of Afghanistan’s fledgling financial system. Although the central bank and the Afghan government have downplayed the crisis and assured depositors that Kabul Bank is solvent, concerns regarding the political economic implications remain.
USIP’s Raymond Gilpin provides context and offers his perspective on this crisis.
- What happened at Kabul Bank?
- Is Kabul Bank strategically significant?
- What are the broader implications for peace and stability?
- Will this crisis affect international partners like the United States?
- What needs to be done to mitigate the effects of this crisis?
What happened at Kabul Bank?
Since its inception in 2004, Kabul Bank has approved a significant number of loans with apparently minimal due diligence. Many analysts have described it as operating like a cash dispensing machine for the well-connected in Afghanistan; thereby becoming the backbone of a system of patronage that has rewarded the political elite. A number of important Kabul Bank shareholders were also believed to be part of this system.
Lax lending practices have contributed to significant portfolio contamination. The bank also approved risky real estate investments on Dubai’s Palm Jumeira Island. The value of these investments -- currently worth about roughly $155 million -- fell by almost 50 percent between end 2008 and mid-2010. Doubts about the recoverability of these assets, the likelihood of repayment defaults and revelations of systemic corruption and cronyism precipitated the crisis, which led to a run of withdrawals from the bank. The Afghan finance ministry and central bank went into damage-control mode, and assured the public that the resignations of Kabul Bank’s top officials fell in compliance with new rules banning shareholders from holding senior operating positions.
However, the subsequent freeze on major shareholders’ assets casts a different light on the crisis and gave rise to speculation about an imminent bailout. Kabul Bank appears to be reasonably liquid in the wake of the crisis, holding reserves equivalent to 40 percent of total deposits --- well above prudential requirements. However, a liquidity squeeze could lead to a loss of confidence and a possible bailout; neither of which would bode well for Afghanistan.
Is Kabul Bank strategically significant?
Kabul Bank is the country’s most prominent commercial bank with the most extensive branch outreach and more than a million customers, including most government employees --- some 250,000 civil servants, teachers, doctors and security personnel. Problems with this bank could disrupt the payments system and contribute to resentment and instability if salaries are delayed. The government has provided assurances that it would act as a lender of last resort if Kabul Bank needs additional capital, highlighting the fact that its nearly $5 billion in international reserves are more than adequate.
However, given Afghanistan’s weak tax effort, any drawdown of reserves would have to be replenished to preserve macroeconomic stability. There are also some doubts about whether the government could use its international reserves to finance a bailout. From a financial sector perspective, resolution of this crisis and possible measures to forestall a recurrence should be considered carefully. Excessive controls and high reserve requirements could stifle the private sector, while a half-hearted solution would be a temporary band-aid at best.
Cultivating a healthy financial system is vital for Afghanistan’s stability. Robust financial intermediation (such as deposit-taking and on-lending) facilitates both enterprise and governance. It also serves as an incentive to improve transparency by reducing informal financial activity – much of which is linked to the illicit drug trade and the conflict economy.
In recent years, Kabul Bank became a prominent feature in the intermediation process. A crisis of confidence and/or collapse of Kabul Bank could adversely impact economic fortunes, the functioning of the Afghan government and the efficacy of aid flows. Informal financial channels could also become much more entrenched.
What are the broader implications for peace and stability?
The crisis unfolded just before the Eid holiday and the September 18th parliamentary elections; a period when households and communities have a high demand for cash. This is likely to worsen the erosion of confidence in the banking system because the crisis will become more indelibly etched in the depositors’ memory. Estimates of withdrawals by depositors in the days following the central bank announcement range from $150 to 300 million, significantly less than the $500 million cash believed to be held by Kabul Bank before the crisis.
Even if the outflow is halted when the banks reopen following the holidays, the bank has a lot to do to repair its image and the central bank must convince the Afghan public that it is a credible overseer of the financial system. If this does not happen, we are likely to witness a shift from the formal system to informal channels, which are much more difficult to monitor. The flourishing informal financial sector in Afghanistan is already awash with dollars from the drug trade. An erosion of confidence in formal financial institutions could push more transactions outside formal channels, thereby reversing the substantial economic reform gains Afghanistan has enjoyed in recent months.
The central bank must take immediate steps to thoroughly investigate malfeasance at Kabul Bank and send clear signals that it is ready to be an effective, consistent, transparent and independent supervisory body. This is an ideal opportunity to introduce some sanity in Afghanistan’s financial sector, depoliticize financial decision-making and protect the depositors.
Furthermore, the Obama administration’s December 2010 review of progress in Afghanistan is unlikely to be complimentary. A similarly dire assessment of the financial system will complicate matters and deepen the crisis of confidence.
This would cast further doubt on the emergence of a capable Afghan state.
Will this crisis affect international partners like the United States?
U.S. Deputy Treasury Secretary Neal Wolin is quoted as saying, “This is an Afghan issue. They are taking immediate steps to ensure the stability of Kabul Bank and protect the financial assets of the Afghan people.” Other Treasury officials have ruled out a U.S.-funded bailout. Afghan authorities have emphasized that they would not be calling on their $300 million deposit in the U.S. federal reserve system to shore up domestic liquidity. Technically, they are right. International partners are unlikely to finance a bailout directly. However, if a capital injection is required and Afghanistan draws on its own reserves, international donors (who effectively underwrite the country’s budget) would be taxed indirectly. It is, therefore, essential to ensure that the strategy to address this crisis is robust and sustainable.
What needs to be done to mitigate the effects of this crisis?
Two immediate steps must be taken. First, Afghanistan’s central bank must demonstrate the willingness to operate as a credible and effective entity, and unveil a plan to develop capacity in critical areas of financial oversight and forensics. Second, independent and verifiable financial and management audits must be conducted throughout the financial sector. This should include stress tests to ensure institutional viability. More widespread portfolio contamination will increase the urgency of financial sector reform and put the issue of a bailout back on the agenda. The size of such a bailout is likely to pressure Afghan reserves and require international assistance.
Financial reform measures will only be effective if concomitant steps are taken to improve the efficacy of the judiciary. The management of Kabul Bank should be scrutinized and prosecuted if necessary. The solution goes beyond the immediate crisis because the Afghan financial sector is too strategically important to fail.